Increased Interest Rates - What It Means For You?

Current You:

Current you has savings sat in a bank account. Current you potentially also has credit cards, a mortgage, a car loan and a sofa bought on finance; you make repayments that are either monthly, ad hoc, weekly, bullet repayments to the bank, building provider, car financing company or furniture outlet. 

Definitions

A repayment consists of either capital and interest or interest only with capital at the end, or renegotiated throughout the loan.  

  • Capital: the amount of money borrowed initially, and 
  • Interest: the amount of money paid to the loan provider, the lender, for the privilege of having the loan i.e like a sales tag. In a shop you spend £2.50 on coffee. To borrow money, you also have to pay an amount for that money. The difference between the coffee and borrowed money though, is that you own the coffee; you don't own the borrowed money - you still have to pay that back.

The rate of interest also determines the money you are paid on your savings.

At the moment interest rates are incredibly low. 

 

How Are Interest Rates Set?

A VERY complicated topic! The below gander is the high level view.

Economy: When the economy is good (i.e people have jobs, investment is occurring in education, healthcare, research etc, businesses are exporting and importing), people have confidence in their money and, more specifically, their outlook; they are less concerned with spending more (shopping eating out, houses, cars etc). 

 

What is the effect of this?

(Demand Side) Inflation: Spending more increases the price of goods (i.e food, transport etc). People have more money to buy these goods, and therefore demand them. As the supply of goods is still catching up with the demand for them, the price of them goes up. The price increase of a good or service over time is inflation. How quickly this rise in price occurs, is the inflation rate. 

How does this impact interest rates?

Interest Rates: Inflation and interest rates are inter-linked. The lender of money needs to charge an interest rate higher than the rate of inflation (i.e if food is increasing at x% per year in price, the lender needs to charge (x+1)%) to make a profit. Thus interest rates increase. This makes borrowing money expensive (you pay more interest for the capital borrowed).

How is it regulated?

Bank of England: Countries try to regulate inflation to maintain a strong economy; this is determined by monetary committees in respective countries. In the US, it's the Federal Reserve. In the UK, it's the Bank of England's Monetary Policy Committee (MPC). The set the Bank of England interest rates; these rates act as a benchmark for interest rates. If there is uncertainty (economic, political, market etc) the MPC can reduce or increase interest rates to trigger or encourage consumer and business behaviour such as spending.

The UK target inflation rate for the MPC to try and regulate (through interest rates and other means) is 2% (set in 2016).

Other Factors

Other factors determine interest rates, including international investment and borrowing, political stability, the stock market, share prices, supply side inflation and government borrowing. 

 

Where Are We Now?

Interest rates have been kept artificially low by the Bank of England for the past 9 years. After the financial crisis of 2008 the economy was weak; individuals had little confidence in their future and outlook, and no confidence in UK financial institutions.

Keeping interest rates low was done to encourage spending in the UK economy, and borrowing again from financial institutions; keeping a flow of capital was initiated to help "get the economy back up again".

Interest rates are predicted to rise in the next 6 to 12 months. 

 

Implications On You?

Pay off Debt: If you have a car loan, mortgage, appliance that you pay financing on, it might be worth paying back as much as possible now. Rising interest rates mean you'll pay more to the lender in interest, not capital.

Similarly, borrowing on credit cards will be more expensive. At the moment, being in your overdraft or in the red on your credit card might only cost a couple of pounds a month. This amount is set to rise if interest rates rate. This could put you very quickly into debt you can't pay back. 

£ Strengthens: Higher interest rates tend to increase the value of currency. This means that you should get more Euros, Dollars, Yen etc for your pound. Even more simply, you are able to buy more abroad for your money. 

Increase Your Savings: Saving rates SHOULD increase. There is normally a lag on these rates against borrowing rates i.e borrowing rates tend to increase followed by savings rates after a period of time. You should see more return for money sat in the bank.

Photo from the beautiful unsplash.com

Wee Scot Finance